Whether Bernanke will be able to convince markets of this will be the first test of his exit-strategy communication skills, Fed watchers also said.

'We think it is important not to confuse the plan for tightening with the intention to tighten.'
Goldman Sachs

In his speech that went into great depth about the nuts and bolts of the exit strategy, Bernanke remarked that the Fed "before long" expects "to consider a modest increase in the spread between the discount rate and the target federal funds rate."

In normal times, banks pay the discount rate, or primary credit rate, when they come to the Fed to buy reserves on an emergency short-term basis.

During the financial crisis, banks were reluctant to come to the discount window out of a concern that they would be stigmatized as weak.

To combat this perception, the Fed lowered the spread between the discount rate and the federal funds rate to 25 basis points from the traditional 100 basis points. But this move didn't work. Banks remained standoffish about using the discount window.

In response, the Fed launched a program, known as the Term Auction Facility, of TAF, to auction credit to banks.

As financial conditions improved, the Fed let several emergency-credit plans expire, and the last TAF auction for credit is scheduled for early March. As a result, Bernanke said in his speech that the Fed would like to "normalize" the discount window.

The central bank reduced the maximum maturity of discount-window loans to 28 days from 90 days, and signaled that officials "before long expect to consider a modest increase" in the spread between the discount rate and the target federal funds rate.

In his remarks, Bernanke bent over backwards to say that the discount rate was not a signal of imminent rate hikes.

The discount rate change "should be viewed as further normalization of the Federal Reserve's lending facilities, in light of the improving conditions in financial markets; they are not expected to lead to tighter financial conditions for households and businesses and should not be interpreted as signaling any change in the outlook for monetary policy," he commented.

But the financial markets did not seem to agree. Short-term yields rose and the dollar strengthened. Stocks fell but recovered later in the day. See the latest on the markets.

Fed watchers rushed to advise clients that a tightening of policy was not imminent. "Although the immediate market reaction to the testimony was negative, we think it is important not to confuse the plan for tightening with the intention to tighten," said the economic team at Goldman Sachs.

Although Bernanke provided several details on the path to an exit that did not prevent him from reiterating that "at present the U.S. economy continues to require the support of highly accommodative monetary policies," Goldman wrote in a note.

David Greenlaw, economist at Morgan Stanley, noted that the possibility of a discount rate hike has flared before the last few FOMC meetings, but nothing happened probably because the Fed has been concerned that a hike in the discount rate would send a misleading signal.

"The fact that Bernanke is now highlighting such a change means it is likely to occur sooner rather than later, but shouldn't be viewed as a policy signal," Greenlaw said.

Fed watchers admitted that any upward change in an official Fed rate could be considered a tightening. But markets should not overinterpret Bernanke's words, according to said Robert Brusca, chief economist at FAO Economics.

"Market participants want the Fed to communicate and be clear in telling them what they think it means, but then the market turns around and says 'Oh no, it doesn't mean that,'" he added. "This is one of those times when you should listen to Fed and take it more or less at its word."

Former Fed governor Laurence Meyer said last month that the Fed was close to raising the discount rate.

He predicted that the Fed would not move the rate without an initial signal from Bernanke precisely because the market might misinterpret the move.

Even with a higher discount rate, Meyer doesn't see the Fed tightening until 2011.

One reason the Fed wants to increase the discount rate well before it feels the need to tighten monetary policy is that the low discount rate has allowed something of a "carry trade" for banks, Meyer said. Banks have been able to bypass the market and borrow at the discount rate and then arbitrage into higher paying liquid assets.

Bernanke will be able to take a second bite of the apple when he discussed Fed policy later this month in another round of Congressional hearings.

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